Cash vs Accrual Accounting: What’s The Difference?

Introduction

Is your small business accounting a little all over the place? Choosing the right accounting method is crucial for effectively managing your resources, time, and tax obligations. This guide will help you understand the two main accounting methods: cash basis and accrual, enabling you to make an informed decision for your business.

What is Cash-based accounting?

Cash basis is an accounting method that records income and expenses only when they are realized (that is, converted to cash). This method focuses small business bookkeeping on the company’s cash flow. So, your books will be updated whenever cash is physically paid out or received.

For instance, if you sell a product in January but receive payment in February, the revenue is recorded in February, when the cash is received. Simply put, it’s recorded if it’s in the bank. 

Pros 

• Simple, intuitive  to use 
• Shows exactly how much cash you have on hand
• Lowers tax liability by changing transaction timing

Cons

• Offers a limited look at your expenses and income
• Not suitable for every business type
• Makes it difficult to switch to other types of accounting methods

What is Accrual accounting? 

Accrual accounting records revenues and expenses when earned or incurred, regardless of when the cash is received or paid. For example, if you provide a service in January but don’t receive payment until February, the revenue is still recorded in January when the service was provided.

Pros 

• Streamlines strategic planning by forecasting future cash flow
• Offers a transparent view of your financial position
• A better choice as the business grows
• Satisfies the GAAP compliance

Cons 

• Switching to the accrual method can be tough
• Requires demanding recording methods to be accurate
• Can expose you to fraud risks
• Not a true representation of your current cash flow
• Might increase your tax liability with unrealized income

Cash vs accrual accounting

The devil is always in the details. Now that you know what both cash and accrual accounting methods are, it’s time to peep into the finer details. Here are the main differences between the two small business expense tracking methods: 

Why is cash-basis accounting misleading?

Cash basis accounting can make a steady business look uneven because it only counts money when it's received or paid out, not when it's earned or owed. This creates a timing mismatch that misrepresents a business’s monthly performance.

For example, a tech company working on a project in January but paid in February would show January as less profitable and February as more profitable, even though the business was consistent across both months. These ups and downs can lead to poor decisions, like cutting costs in a seemingly "bad" month or overspending in a "good" month. 

Should small businesses use cash or accrual accounting?

When you’re a small business, picking an accounting method with IRS compliance is important. But it’s also important to make sure your bookkeeping method aligns with your business’s needs— both present and future. Here are five factors to consider when you pick your accounting method: 

1. Business size and revenue level

Small businesses with simple operations and lower revenue will find that cash basis accounting is easier to manage. It also qualifies for IRS use of the cash method, especially if their average revenue for 3 or more years is under $25 million. 

On the other hand, larger businesses with higher revenues, more complex operations, or inventory might be required to use accrual accounting. This isn’t just to handle the complexity of your operations but also because you’ll be legally required to switch to accrual accounting for IRS compliance!

2. Industry best practices

Certain industries have standard accounting practices that are widely used. For example, businesses that deal with long-term contracts (like construction) or those managing inventory (like retail or manufacturing) often use accrual accounting to better match expenses with revenues. Look into what is typical in your industry and follow up on it!

3. Plans for growth

If your business plans to expand or seek external funding from investors or loans, accrual accounting will serve you well. It provides a more accurate picture of long-term financial health, which is crucial for investors and financial institutions when assessing a company’s viability. 

On the other hand, cash basis accounting will get complicated and messy when your transactions increase in quantity as your business grows. So think about your future growth trajectory. If you're aiming to scale quickly, you’ll want to adopt accrual accounting early to avoid transitioning later.

4. Complexity of operations

The level of complexity within your operations is one of the top factors that influence your accounting choice. Accrual accounting will be your jam if your business has complex transactions, such as: 

• Dealing with multiple receivables or payables,
• Handling large volumes of inventory,
• Having long-term contracts,
• Getting deferred payments, or
• Going through a high volume of transactions.

However, if you’re a rather simple small business that doesn’t exactly identify with the above, cash-basis accounting will work just fine for you!

5. Your resources and time

Each business has its own unique set of resources. Therefore, picking the right accounting method depends on what best aligns with those resources. If you have plenty of resources at your disposal such as automated receipt management tools, sophisticated accountants, and time, accrual accounting will be a high possibility for you.

Evaluate whether you have the internal resources— or the budget for external help— to maintain accrual accounting. Small businesses with limited staffing should opt for cash basis until they grow and can afford to invest in more complex accounting systems. Cash basis accounting is simpler and requires less oversight!

Legal and tax implications

You can’t pick an accounting method without considering the legal and tax implications of each. While the IRS allows small businesses to choose between cash and accrual accounting methods, they place some restrictions. 

For instance, you must choose accrual accounting if your sales for 3 years have been over $25 million. Furthermore, businesses that produce, purchase, or sell inventory are generally required to use accrual accounting to accurately match revenue and the cost of goods sold (COGS) in the same period.

If you want to save money on taxes, you’ll want to pick cash-based accounting because it prevents you from paying taxes on income that hasn’t been realized. It also allows you to change transaction timing to show more incurred expenses and lesser income, leading to lower taxes. 

The role of expense management software

For every small and budding business, the question of cash vs accrual accounting is important. Not only does it impact how much you pay in taxes, how you proceed legally, and the time it takes to record, but also how many resources you need to employ. 

When it comes to resources and time for your business, automated receipt tracking software can save both! Receiptor AI is the leading accounting software option that helps your business record and keep track of all your bookkeeping entries, reducing the need for manual bookkeeping and the man-hours that come with it. 

But it doesn’t just make your present easier— it’s prepped for the future! As your business scales, so does Receiptor AI. No matter the accounting method you choose, we simplify your accounting, accurately record all your financial data, and free up your time so you can focus on strategic financial management and planning!